Donald Trump, angry Americans and misapplied trade theory

Americans are angry. One well-defined cause of their anger is the lack of jobs to replace the ones lost to global trade.

The "Ricardian" definition ofComparative Advantage– the DNA that powers global trade – may have been misapplied. Since 2005, the United States may have gone overboard in its offshoring and outsourcing. Much of what was sent overseas need not have been sent.

Many of the jobs that were lost in industries in which the U.S. supposedly had aComparative Disadvantage, may actually have been sectors ofComparative Advantage, which needed to be not just kept at home but also increased for exports.

English economist David Ricardo’s concept ofComparative Advantage(CA) from the early 1800s powers all free trade models. It still works, it just needs to be used correctly.

A lightning explanation of Comparative Advantage

In this very simple example, we have 2 countriesAandB, making two goodsXandY, and they each have 100 units of labor, defined asL.

Let’s defineALX= 2, as in 2 workers needed to make 1 unit of Pharma inA. For example,BLY= 10, which is 10 workers needed for 1 unit of clothing inB, and so on.

Ricardo pointed out that even thoughAcan make pharma and clothing with fewer workers thanB, countryAmakes pharma more efficiently (with just 2 workers) whileBtakes 8 workers---four times as many. Aalso makes clothing with fewer workers thanBcan (5 compared to 10).

In other words, let’s say that you do IT strategy at work, for example, and you do this better than your assistant. But you can also put together the handouts for the big board meeting better than your assistant, too! So should you do it all? No. Let your assistant still make the handouts for the board meeting – your time is too valuable to be doing it all.

In other words, the opportunity cost incurred by you in preparing your handouts is too large. You need to just do IT strategy, since you do IT strategy more efficiently; according to Ricardian trade theory, you have a comparative advantage (CA) in IT strategy.

Algebraically, this translates toALX/ALY<BLX/BLY. In this case,Awould have a comparative advantage (CA) in makingX, and therefore countryBwould have aCAinY, with the inverse being true. In plain English,Awould makeXmore efficiently (at less opportunity cost) thanB.

Ricardo then went on to prove that countryAshould specialize in making more pharma (GoodX), and basically phase out (or de-emphasize) the making of clothing (goodY), and then trade with countryBwhich has aCAinY.

CountryBmakesY(clothing) more efficiently and so countryAimportsYfromBand exportsX(pharma) toB. Both countries would be able to consume more pharma and clothing by virtue of this specialization driven by how efficiently each makes X and Y –the differences inCA(0.4 compared to 0.8) drive the extent of specialization. The greater this difference, the more ofY(clothing/furniture/manufacturing) will be dropped byAand the more willAemphasize the output inX.

So the workers in Pharma (goodX) are happy---more jobs, more pay, they are exportingXto the world. But what happens to those who were inY(clothing/furniture/appliances/manufacturing in general)?

English economist David Ricardo's concept of Comparative Advantage from the early 1800s powers all free trade models. Photo credit: carolsandresantas/iStock/Thinkstock.

Source of the anger

Trade theory would show that, maybe with a short lag, the workers inYwould transition to new jobs, and their kids would certainlynotlook for careers in theYsector. Over time, theYworkers would transition to theXsector. But herein lies the problem – this transition has largely not happened in America. And theYpeople are frustrated, bewildered, and angry.

So these free-trade-affected angry Americans are flocking to Donald Trump and also the Bernie Sanders camp! Here’s how we got here:

1.Ricardo’s free trade model was misapplied, and with tragic consequences. When our companies went on their monstrous offshoring and outsourcing spree of the mid-1990s, they were obsessed primarily with the lower labor costs there (inB).

They did not factor in other costs that would negate, or largely erode, the lower labor costs. Factors in countryBsuch as infrastructure problems, corruption issues, intellectual property violation challenges, regulatory hurdles, huge worker turnover with each new batch of workers having to be re-trained, inconsistency in quality, rapidly rising wages inB, and expensive executives to be hired here at home to monitor the outsourcing challenges inB.

So, to adjust for these costs, let’s adjustBLXfrom 8 to 10, andBLYfrom 10 to 15, to include the extra costs of doing business inB. Now suddenlyBLX/BLY= 0.67, and not 0.8 anymore. Remember, the differences in these ratios drive the amount of specialization.

2.Ricardian trade theory is all applied microeconomics. It completely missed the micro-macro interface. In other words, it missed the effects of the major macro recession such as the one that has hammered the U.S. since 2007, the greatest recession since the Great Depression.

Trade theory missed the effects of unfriendly business regulation here in the US that drove U.S. business overseas. It missed increased healthcare expenses thanks to Obamacare and also ignored the anti-business tax rates (one of the highest tax rates in the OECD) that make production ofXinAso difficult. So with that, let’s increaseALXto 3, to incorporate the extra cost of doing business inA, due to, for example, more intrusive regulation, high corporate taxes, union pressure and a crumbling US infrastructure.

Now suddenly the ratios have become (ALX/ALY) = 3/5, and (BLX/BLY) = 10/15.

Interestingly, we see that the gradient in comparative advantages is 0.6 forAand 0.67 forB! In this case, by implementing “effective”CA, we see that the differences inCAare not nearly as pronounced (0.4 versus 0.8 earlier), and consequently, if we had incorporated all the real costs in our analysis, much less ofYwould be offshored.

There would be fewer angry, frustrated, unemployed workers in many sub-sectors of theYindustry. Today, these former workers in theYsector are the "salt of the earth" workers, many of whom are now flocking to Trump’s banner feeling betrayed by global trade, and are now fertile ground for the xenophobia that is rearing its ugly head.

EMBA alum, Al Porcello, described the misapplication of Trade Theory as, "The difference between physics and engineering. Physics problems always discuss an 'ideal' object on a frictionless surface... every engineer knows that no object is ideal and they cannot ignore friction. We’ve been ignoring friction for too long."

Associate Dean Joe Schaffer, former head of human resource at a Fortune 50 company and the current dean in charge of Rutgers Business SchoolExecutive Education Mini MBA programsand of the Asian International Executive MBA programs, brought this perspective: "Back then, outsourcing and off-shoring were totally driven by costs overseas — in fact, it was all driven by our bonuses, many of which were 100 percent of our salaries. Bonuses in the real world drive people to make some pretty bizarre strategic decisions. Short-term profitability tied to bonuses was all that mattered!”

3.Another factor driving this persistent unemployment is the housing crisis. With a large portion of homes "underwater" following the bursting of the housing bubble, job mobility became a casualty. Workers could not afford to sell their homes and move to a different part of the U.S. where jobs were available. U.S. labor mobility, long the envy of most mature economies, was severely hamstrung by the collapse in home prices.

4.Finally, this time around the “new” industries and technologies are not creating the number of jobs that accompanied past introductions of new technology. Facebook only has about 3,000 employees that handle over a billion clients. Twitter has even fewer. And the new technologies are, very controversially, not new technologies that are necessarily path-breaking. Do we really think that storing 50,000 songs and 3,000 movies on our watches (1,000 of these movies on the “silly things cute animals do”) will make the world a better place?

Red herrings in the news

Free trade deals like NAFTA and the TPP have been blamed for the current crisis. This is nonsense, red herrings, all of them.

Trade will happen irrespective of official free trade deals – stopping trade is like trying to stop water from flowing downhill. Trade is endogenous; it will happen. The sooner we realize that trade is driven by effectiveCA, the fewer sectors that will be mistakenly disrupted here at home, and the fewer lives we will disrupt.

High quality U.S. furniture lines should have stayed home. Photo credit: Nastco/iStock/Thinkstock.

And the fewer brands we will lose forever, and for no reason. For example, high quality US furniture lines should have stayed at home making high-end, quality furniture. Now, even affluent Chinese consumers are insisting on buying furniture made only in America for obvious reasons. And this domestic furniture is increasingly hard to find, as typically, sectors that are disrupted and offshored, hardly ever come back.

Right now all these disaffected workers in IndustriesYare the “angry moths” flying to the Donald Trump banner.

An answer to Trump

We need to understand that some—some—of the angry moths flying toward the light of Trump are angry for legitimate reasons that pertain to misapplied free trade. But, I fear that the light to which they fly to, is not real. It is the false light of a false prophet.

To make the "angry moths" happy, we need to fix the “misapplied” Ricardian trade issue. We have to useEffective Comparative Advantagein decisions pertaining to outsourcing and offshoring, remove the macroeconomic impediments to trade here by unleashing supply side economics, by eliminating high taxes and excessive regulation. It’s time to fix crumbling infrastructure with a combination of limited and highly focused Keynesian spending on infrastructure and education.

And finally, we must remind the American public that nations, like individuals and like companies, show their real character when times are bad—in bear markets. We are in one now. The eyes of the world are on us. We must exhibit grace under pressure. This nation of immigrants can still show the world that it can again exercise global leadership and that “government of the people, by the people and for the people shall not perish from the earth.”

Farrokh Langdana is director of the Executive MBA Program and a professor of finance and economics.